With Mutual Funds, you may not be as Diversified as you Think

Mutual funds are attractive because they offer diversification in a single investment. But owning a mutual fund doesn’t mean that you’re properly diversified. Here’s what to look out for.

Out of all the investment products out there, the one you have probably heard most about is the mutual fund. Ironically, you may still not know quite what to buy.

You’re not alone – there are more than 14,000 different mutual funds available. It’s not easy to wade through that and find one perfect fund that fits you better than that sweater your mom knitted for you last Christmas.

Let’s assume that you do some research on mutual funds and come to the conclusion that XYZ Equity Growth Fund matches what you were looking for: low fees and positive returns over the last 10 years. First of all, congratulations! Believe it or not, many people freeze up when faced with all the options and end up never pulling the trigger, keeping their money in bank accounts where it stagnates and never realizes its potential. You decide to contribute $100 a month into the fund and let it ride.

One day you check the account and see it’s been doing well. You’re up more than $20,000 already. Great! But there’s a problem —you might not realize it, but you may no longer be diversified. How could that be? Aren’t mutual funds by definition diversified investment vehicles managed by Wall Street’s best and brightest to make sure everything stays within the proper risk parameters?

Yes and no.

Diversification when you have nothing invested is essentially meaningless, but once you start building a base of capital, it becomes more and more important to spread risk across more asset classes to minimize the potentially negative effects associated with the market.

Here are a few “don’ts” when it comes to investing in mutual funds.

1. Don’t assume that a single mutual fund is one-size-fits-all.

Let’s take the XYZ Equity Growth Fund example: Let’s say it invests in around 100 mid- to large-cap U.S. growth stocks. Not bad, but what is it leaving out? Small cap stocks, international stocks, value stocks and bonds should all be part of a well balanced portfolio.

2. Don’t be duped by the term “balanced funds.”

Balanced funds are some of the more misleading investment vehicles out there because they sell themselves on the fact that they have exposure to all the above asset classes listed. Unfortunately, the relative balance between the types may not align with your risk profile. If you’re an aggressive investor, then balanced funds probably aren’t for you. They tend to split somewhere around 60 percent into stocks and 40 percent into bonds.

That’s fine if you lean conservative, but it doesn’t really work if you’re anything other than middle of the road in your investment philosophy. And when you are young, you shouldn’t be middle of the road — you should be aggressive!

3. Don’t be too trusting.

Another risk associated with mutual funds is management performance. Even if you are a moderate investor and you own a balanced fund, you’re running the risk of trusting one investment team, or even just one manager to be the sole decider of your investment. What happens if he or she retires or the team changes? The next group may not share the same ideals, and past performance is certainly not indicative of future results.

Mutual funds are not static vehicles. Many times companies get absorbed into others and different mutual funds will get combined to form a new one. If you’re not keeping an eye on your money, you could end up owning something totally different that what you originally signed up for.

Mutual funds are wonderful investment vehicles that can you on track for retirement or whatever your savings goals are, but make sure you stay vigilant. Don’t assume that you need a dozen different funds either. Famed investor and founder of Vanguard, John Bogle, was an advocate of keeping a delicate balance when it comes to diversification. Too little and you run the risk of catastrophic collapse; too much and you run the risk of diluting your gains and under-performing the market.

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About Daniel Cross

Daniel Cross has been in the industry as an investment writer and financial advisor since 2005. He holds the Chartered Financial Consultant designation (ChFC) as well as Series 7 and Series 66 licenses, and has embarked on the arduous journey of obtaining the coveted CFA designation. Daniel lives in Florida with his wife, daughter, and pet Tortoise ironically named Turbo.

Comments

Also, a lot of people try to diversify by having 10 different mutual funds, but if all the mutual funds own basically the same stocks you haven’t really diversified much.

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Where can you turn for simple non-judgmental financial advice as you start out? I'm David; I started Money Under 30 because I know how hard it is to get ahead. For seven years I've helped readers create better habits, beat debt and build real wealth. How can I help you?

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